I originally came from the technology sector where business
valuations were based on how much your company was growing. The higher the better and the valuation was
based on some future amount of earnings potential – most often a wild guess.
However, I was talking to a potential client the other day
and I found my self disappointed when I heard how much he had grown
recently. That is because for non-technology
mainstream businesses, growth can lead to some challenges in valuation,
financing and selling a company.
For example, we represent a company right now that has grown
substantially in revenue and earnings for the past three years. They developed a nice specialty, and now are
selling into a market that they were not in three years ago. To me, it is pretty clear that they are a
different company than three years ago, and it is unlikely they would fall back
to that level of revenue.
So we used a valuation number that is based on earnings
somewhere between last year and this year.
Admittedly that was a guess, but I tried to use a number that would be a
safe number to estimate what the future may look like. The problem is that many lenders use a
“standard” calculation of a weighted average of three years, and this appraisal
is used by the lenders to base a lending decision on. In other words, the earnings of three years
ago is still used in the calculation to determine value.
For our current client this means we are selling the company
for one value, but we can only finance it based on a lower value. Even if a buyer agrees with us that the
company is worth the extra value, if he can’t get the financing then he can’t
buy the company. This is where creative deal structuring comes
in, but that takes a lot of time and effort and sometimes unnecessarily
complicates a deal. Or kills a deal.
What a difference between my work in the technology sector
and the work I’m doing now! In a high
growth tech company you can use an earnings number in the future which can
drastically pump up a valuation over current numbers. However for a mainstream company that is
growing, you typically have to average in the past three years which can pull down
the valuation substantially.